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Rackspace Hosting (
RAX
) has increased almost six-fold in value since its August 2008
IPO, largely due to impressive growth in subscriber base, revenue
and earnings per share. Trading at 65 times 2013 earnings, a
stunning
PE ratio
, investors might want to rethink the appropriate valuation of
this cloud hosting service provider - or maybe not.

What is cloud computing? With cloud services, companies can
lower information technology (
IT
) costs by outsourcing hardware and software functions to
third-party vendors via the Internet. In a public cloud -
dominated by rival Amazon's (
AMZN
) AWS offerings, businesses can lower costs by accessing shared
services like storage and server power; private clouds are an
alternative option - the customer's dedicated infrastructure can
be managed by an outside vendor on or off-site. Whereas Amazon
dominates in the former market, Rackspace has focused on the
latter: Rackspace generated $246.4 million, or 77.3% of total
sales, in rental fees for its proprietary private cloud services
in the second quarter.

The growing demand for non-PC mobile devices and content is
driving a seemingly endless demand for data transmission and
storage. Cisco Systems (
CSCO
), for example, estimates that global Internet traffic will jump
nearly fourfold during the next five years, hitting 1.3
zettabytes per year by 2016. A zettabyte is equal to about 1,000
trilliard gigabytes!

By 2014, it is estimated that more than 50% of all workloads
will be processed in the Cloud. Spending in the global market for
cloud computing is forecasted to grow almost six-fold to $241
billion in 2020. Market research firm Forrester estimates, too,
that the total size of the public cloud market will grow from
$25.5 billion in 2011 to $159.3 billion in 2020.

To date, Rackspace has capitalized on this compelling cloud
computing story. Notice the correlation between earnings growth
and price gains in the following YChart for the company:

Virtualization technologies, which multiply server capacity,
are rapidly reducing the number of servers needed to power
networks. Though this paradigm shift lowers the cost of Internet
cloud-based computing - making cloud services more appealing to
potential customers - the lower infrastructure start-up costs
also lower the barriers to entry, threatening Rackspace's
dominance.

Of concern, too, the bandwidth suppliers that Rackspace
depends on to carry its subscribers' data traffic smell potential
profits in the air. Looking to become top-tier cloud service
providers, telecom providers CenturyLink (
CTL
) and Verizon (
VZ
) both made multi-billion acquisitions of cloud computing firms
last year. Expect other telecoms to follow suit.

Nonetheless, San-Antonio-based Rackspace is hoping to
differentiate itself from the thundering herd by developing
product offerings built around OpenStack, an open-source cloud
platform. The differentiating benefit, according to chief
executive Lanham Napier, is that customers wouldn't be locked
into a "static product" like Amazon's Web Service.

With growth in the Cloud showing no signs of slowing, premiums
being paid to get onboard the fluffy white train are
accelerating: In January 2012, software giant Oracle (
ORCL
) spent $1.5 billion, or 68 times trailing twelve-month EBITDA,
to acquire RightNow, a provider of customer-service centers for
the Internet; and, in May, global software leader SAP AG (
SAP
) plunked down $4.3 billion, or 106 times trailing twelve-month
EBITDA, to purchase Ariba, a leader in cloud-based collaborative
commerce applications. Prior to these two deals, the average
ratio of six enterprise software and service deals of more than
$1 billion was 17 times EBITDA (since 2006) in the U.S.,
according to Bloomberg News.

Ergo, with Rackspace priced at a premium of only 26.7 times
trailing EBITDA, what appears to be expensive to potential
stockholders today could look cheap a year from now, ad could
look very cheap to a potential acquirer. In any market
transaction, however, the principle of caveat emptor always
applies: Should anticipated offerings founded on OpenStack be
delayed or power outages disrupt services and average monthly
revenue per subscriber - i.e. profitability - "let the buyer
beware."

David J. Phillips is a contributing editor at YCharts,
which includes the just-released
YCharts Pro Platinum
for professional investors.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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